No indexation: Sale of homes needs to be taxed at the same rate as salary income

In an ideal world this is something everybody working in a public service function should believe in. Or if I were to slightly reword this, this is something everyone working for the government and its different institutions should believe in.  

India’s income tax bureaucrats, the ministry of finance and the Union government didn’t seem to believe in this for many years when it came to India’s income tax system, which is rigged in favour of non-salaried and non-interest income and those earning it.  

In that sense, there was no equity in the way in which different kinds of income was taxed, with salaried and interest income being taxed at the marginal rate, whereas income made from capital gains on different kinds of investment being taxed at lower rates or not taxed at all. 

Of course, those who earned money through this inequitable way have always thought of this as their birthright. But let me not jump the gun here.   

In the budget presented on 23 July, the Narendra Modi government removed the indexation benefits available while calculating the income tax to be paid on the long-term capital gains made on the sale of immovable property (land, residential homes, etc.). 

Up until 23 July, if a property was sold 24 months after it was bought, indexation, or accounting for inflation while calculating capital gains, came into the picture.  

Let me share a very simple example here just to explain the concept of indexation to those who do not understand it. Let’s say you buy a flat for ₹50 lakh. Three years later you are ready to sell it for ₹60 lakh. The gain here is ₹10 lakh, but that does not take indexation or inflation into account.  
Now, let’s say the total inflation during the three year period was 15%. Indexation allows this inflation to be taken into account while calculating the price of the flat. So, the price of the flat after indexation turns out to be ₹57.5 lakh (1.15 times ₹50 lakh). The long-term capital gains after taking indexation into account work out to ₹2.5 lakh ( ₹60 lakh minus ₹57.5 lakh). A tax of 20% or ₹50,000 in this case, needed to be paid on these capital gains. (The actual calculation for tax purposes is slightly more complicated. The idea was to keep things understandable, hence, this simplistic example.)  

As can be seen from the example, indexation really helped in lowering the total amount of tax paid on long-term capital gains made on the sale of a flat. An income tax of ₹50,000 was paid on an income of ₹10 lakh ( ₹60 lakh minus ₹50 lakh), an effective rate of 5%.

Now, this was wrong on several counts.  

First, this system favoured income from investing in real estate over income from salary or interest earned. While salaried income and interest income were/are taxed at the marginal rate of income tax, long-term capital gains made from real estate were taxed at a significantly lower rate after indexation was taken into account. Sometimes, indexation even led to losses, which could then be set off against taxable income.  

On the flip side, anyone who earned a salary, and let’s say got a bonus of ₹10 lakh during a year, would have had to pay a tax of ₹3 lakh if they fell in the 30% tax bracket. Of course, those earning a salary and those making money from real estate could both be the same individual, and hence, you would expect them to argue in favour of the indexation system continuing.  

Second, this system incentivized investing in real estate than let’s say investing money in a fixed deposit. After people had bought a home to live in, they bought more homes for investment purposes and kept them locked. 

In a recent interview to The Indian Express, G. Hari Babu, the National President of National Real Estate Development Council (NAREDCO)—a real estate industry association—said: “There are 1.14 crore flats lying vacant in India. These are being bought as investment opportunities."  

That was not the first time such a comment has been made. In 2015, Anshuman Magazine, the then chairman and managing director of CBRE South Asia, a real estate consultant, said: “Despite a housing shortage, around 1.02 crore completed houses are also lying vacant across urban India."  

Of course, those investing in real estate like to argue that investing in real estate is more risky than investing in a fixed deposit or earning a salaried income. Well, for one, no one forced you to take on that risk. Further, by buying a flat and keeping it locked, you guys beat the entire purpose of building flats, turning a physical asset into a financial one.  

That brings me to the third point. By turning a physical asset into a financial asset, things have been made very difficult for people looking to buy a home to live in. While real estate prices haven’t really gone up much in the last decade they haven’t fallen either because people buy flats and keep them locked—of course, among other reasons. 

(Okay, I am not talking Gurgaon and South Mumbai here or even the IT corridor of Bengaluru, but do try checking out the prices of flats across many DDA societies in South Delhi and you will perhaps get what I am trying to say.)  

This dynamic has basically ensured that flats in our cities continue to be very expensive, making things difficult for those looking to buy a home to live in. So, a shortage and a glut exist at the same time because the price that the demand side can pay is not the price that the supply side is willing to accept. So, the equilibrium that clears any market is not properly arrived at.  

Fourth, the lack of equilibrium explains at some level why our cities are full of slums—very visible in Mumbai and not so visible in Delhi and Bengaluru—given that the supply of homes is not at the price levels at which demand can exist. And the tax system incentivises this, or at least used to. The richie rich—who like to use terms like middle class and upper middle class—have poured their money into real estate and kept it locked.  

Fifth, the production of things like cement, glass, plastic, steel, and ceramics that go into the building of homes involves the emission of greenhouse gases. There is also construction dust. If no one is living in these homes, then what’s the point? So, dear readers, why are so many of you hell-bent on leaving behind a much worse world for your kids and grandkids? (I can’t say we here because I don’t have kids.)  

Sixth, locked homes have led to over-expansion of our cities, requiring longer commute times and delivering a lower quality of life. If you are wondering where all those traffic jams stem from, this is also one reason. Of course, it also impacts the financial savings of those buying expensive homes to live in.  

Seventh, a capital deficient country like India shouldn’t be encouraging the building of locked homes.  

Taking all these points into account, the Narendra Modi government’s decision to remove indexation benefits available on the sale of real estate was one of the few good decisions it has made on the economic front in all these years.  

But this immediately led to protests from the well-to-do—the big mutual fund agents, the chartered accountants, the registered investment advisers, and many others in the business of making money from pretending to manage other people’s money—and who also like to pretend that they are middle class.  

And after all the noise they had made, on 6 August, the government decided to partly withdraw the removal of indexation benefits. Anyone who bought a flat, a house or land before 23 July can continue to avail indexation benefits while calculating income tax, as long as they are resident individuals. They can pay a tax lower than 12.5% without indexation and 20% with indexation on the long-term capital gains made. 

Now, this is fair to the extent that any introduction of taxes shouldn’t be retrospective in nature, but it does hurt India’s huge housing crisis in cities.  

Further, non-resident Indians (NRIs), overseas citizens of India (OCIs) and companies won’t get indexation benefits while selling property, even if it was bought on 23 July or earlier. Also, if using indexation leads to a loss on the property transaction, that loss cannot be set off, and a tax of 12.5% as per the new system will have to be paid on the capital gains made without indexation.  

The government brought this change after financial influencers went berserk on social media protesting against this move. As David Friedman writes in Hidden Order—The Economics of Everyday Life: “If the cost of the law is diffused among many people, no one of them will find it in his interest to discover what is being done to him and oppose it. That is one reason why special interests are so successful in benefiting themselves at the cost of the rest of us-even though we outvote them a thousand to one."  

The special interests were successful in this case as well, at least to some extent, in getting the government to partially reverse the doing away of indexation benefits. 

These special interests have offered multiple arguments against the government’s original decision of doing away with indexation. Let’s look at them. 

First, one argument is that capital gains tend to be taxed at rates lower than income tax rates in many countries. That’s true to some extent but not as much as we are told. Also, long-term capital gains, which set in just after two years of owning a property, will be taxed at a very low 12.5%. The system continues to be unfair to salaried and interest income.  

The same stands true for long-term capital gains made on selling and buying of stocks and equity mutual stands. In this case an ownership for more than just one year is classified as long-term. How can owning anything for one year or two years be classified as long-term? It just doesn’t make any sense.   

Also, as can be seen from this list maintained by PWC, capital gains in many countries are taxed at the personal income tax rate. So, saying that capital gains everywhere is taxed lower than salaried income and interest income is wrong. (Thanks are due to Harsh Roongta who pointed to this excellent source of data in his terrific column in the Business Standard.) 

Also, going through this list one can see that the 12.5% rate of taxation of long-term capital gains on immovable property or even stocks for that matter is pretty low by global standards.  

I see no reason why all income shouldn’t be taxed at the same rate. Intelligent and smart chartered accountants shouldn’t be spending their lifetimes doing low value-adding work of filing income tax returns. There are better things that the society at large can use their brains for.  

Second, we are being told this change will only lead to the black money in the system going up. This sounds like a sensible argument but it isn’t. Black money can be a part of real estate transactions only when the circle rate on which stamp duty has to be paid to the state government is lower than the market price at which real estate is selling. A change in indexation laws does not change that. 

If the circle rate continues to be lower than the market price, black money will continue to exist in the system. This has got nothing to do with indexation and has only been offered as a reason by those who used to benefit from indexation to mislead us. So, things can’t get any worse on this front because of this change.  

Third, we have been told that the building of real estate creates employment, but so does digging holes and filling them up. But digging holes and filling them up cannot be a process for employment creation at all points of time. Creation of any physical asset leads to usage of resources. And these resources can be used for other economic activities.  

Take the case of building homes in which no one will live. It needs civil engineers and masons. As my friends in the business of creating India’s physical infrastructure tell me, it is difficult to find skilful civil engineers and skilful masons. On top of that, if real estate companies creating physical assets that are basically financial assets also compete for them, it doesn’t make the situation any better.  

Fourth, we are being told this change will make no difference to real estate prices in the country. Those who have bought and kept homes locked can continue to do so in the future as well. Sure, that may turn out to be the case.  

But it does discourage individuals to some extent from buying real estate just as a financial investment. Also, NRIs and OCIs—who have been in the habit of buying a lot of homes and keeping them locked, either for investment purposes, or for emotional reasons, where they hope that they will come back and live in India after retirement, or that their progeny might want to come back to their roots—will be discouraged to do so now on.  

Now, there are no guarantees that this will lead to home prices coming down or remain stagnant for that matter. But what needs to be kept in mind is that the government can only do what it can do, and it needs to do that. At least, indexation benefits won’t be available from 24 July on for resident Indians and that might have some impact in the years to come. This is a complex problem and one move by the government is not going to solve it.  

Finally, to conclude, those who have made the most noise against this move have the most to lose. They have bought homes as an investment. With a low rental yield of 1.5-2% (annual rent expressed as a percentage of market price of a home), they don’t want to rent out their homes and thus keep it locked. Plus, it’s not easy to throw out a tenant who refuses to leave, discouraging renting out further.  

Clearly, they have been banking on paying low-taxes as and when they sell out. And that continues to remain in place. Of course, anyone who can buy a home and keep it locked is clearly not middle class or even upper middle class, despite a lack of a proper definition of the term. Dear reader, there will always be people richer than you are, but that doesn’t make you middle class. Everything in life is relative, but that doesn’t mean that you are doing badly.  

Finally, in the days to come, the government should gradually move towards taxing different kinds of income in the same way at the same rate of tax, simply because India needs more people to be able to buy homes and live in them, and not buy homes and keep them locked. 

India is a country of the young, with the median age being less than 30. The youth want to buy homes to live in. And a part of economic development of a nation is also the increasing ability of people to live lives in cities in homes bought at affordable prices. 

There can’t be any other point more important than this in deciding how to tax long-term capital gains on the selling of homes. And if this is not possible, then the definition of what can be categorised as long-term needs to go up—to begin with, it needs to be at least five years.